Vikram Shah works as a portfolio management for Heddon Investment Advisors. Shah is meeting with the Investment Committee of a corporate pension fund to discuss portfolio performance, and strategies and techniques used in the management of the pension fund. For the meeting, Shah has collected the information in Exhibit 1.Exhibit 1Selected Financial Information

Large Cap U.S. StocksInvestment Grade U.S. Corporate BondsEmerging Market Stocks Expected Annual Return (%)11816 Expected Standard Deviation of Annual Return (%)14622 Return Correlations Large Cap U.S. Stocks1.00.30.4 Investment Grade U.S. Corporate Bonds---1.0-0.1 Emerging Market Stocks------1.0 Shah explains that his firm uses mean-Variance portfolio analysis to guide asset allocation. He states,” we use mathematical techniques to identify a set of efficient portfolio. From this set we select a portfolio that best matches out risk preferences. The pension fund assets are currently invested in the following proportion: 60% U.S. large cap stocks, 35% U.S. Investment grade corporate bonds, and 5% in emerging market stocks. Our analysis suggests that we should modify our current allocations so that the new allocations are: 55% U.S. large cap stocks, 30% U.S. investment grade corporate bonds, and 15% emerging market stocks. This reallocation will result in a mean-variance efficient portfolio that is better aligned with our risk preferences.”

Jerry Cramer, a member of the investment committee, wants to know how correlations between securities and the number of securities in the portfolio impact a pension portfolio’s diversification benefits.

Shah responds,” as the correlation between securities in a portfolio increase, the risk reduction benefits of diversification decrease. Furthermore, as correlation between securities in a portfolio rises, the number of securities in the portfolio must be increased in order achieve a certain level of diversification benefits.”

Another board member, Kala Amato, notes that no part of the pension portfolio is invested in a risk-free asset. She wants to know the impact of combing the current portfolio with an investment in a risk-free asset.

In response Shah states,” If we combine our portfolio with an investment in a risk-free asset, the result will be a new linear efficient frontier that is referred to as the Capital Allocation Line (CAL) or the Capital Market Line (CML). The risk and return of the resulting new portfolio will be linear combinations of the risk and return of the risk-free investment and our portfolio.”

Cramer asks Shah,” Can you explain the model that you use to select stocks for inclusion in the equity portion of the pension portfolio?”

Shah responds,” At Heddon, the primary model we use is a multi-factor model where the factors are: Price to earning ratio, financial leverage, and market capitalization.”

Shah moves on to a discussion on how Heddon Investment Advisors assesses portfolio risk. He states,” we use a risk model to decompose active risk into the following two components:

Components 1

This component is referred to as active factor risk. This is systematic risk attributable to differences in factor exposures between the portfolio and the benchmark. Note that the factors in our model are: Price to earning ratio, financial leverage, and market capitalization.

Components 2

The second component is a function of the individual asset’s active weight in the portfolio and the variance of returns unexplained by our three factors. This component is the active specific risk or asset selection risk.”

Shah continues,” we prefer to structure our portfolio such that, in addition to being on the efficient frontier, relative to the benchmark, it titles toward stocks of large capitalization companies with lower P/E ratios and have lower level of leverage. Exhibit 2 shows the factor sensitivities for the recommended portfolio and the benchmark.”Exhibit 2Factor SensitivityFactorPortfolioBenchmark P/E Ratio-0.25-0.35 Financial Leverage-0.60-0.40 Market Capitalization0.500.35